An introduction to options

Disclaimer: This piece is solely for educational purposes to better understand the financial markets and should not be taken as investment advice. Options are a leveraged instrument (you can end up losing more than your initial capital) and thus considered riskier than stocks. Approximately 90% (this figure may actually be higher, there are some conflicitng studies) of retail traders end up losing money. Being in the top 10% requires a lot of discipline, emotional resilience and fortitude, and trading is not a get-rich-quick scheme Thus, if you are a beginner, I would reccommend you read other resources befoer this, this piece is more suited for those who already have knowledge about the markets. For this piece, I will be explaining about American options as the US has the largest options market. European options have some slightly different characteristics.

Options are derivative (dependent on an underlying asset) contracts that involve a buyer and a seller, with the buyer of the contract having the right to buy or sell a stock at a pre-determined price (buying and selling an option contract does not mean buying and selling the underlying stock, I will explain about it in section 2) any time before the option contract expires. Options can be used to bet on the direction of movement of a stock price which is why they have gained steam this year: 9 out of 10 of the busiest option trading days since 1973 have been in 2020, and as we know, 2020 has been a choppy year for the markets.

1. Elements of options contracts

2. Call and put options

3. Why options?

4. Factors affecting price of option contracts

5. Conclusion

1. Elements of options contracts

Premium: This is the price of the contract itself. The price depends on a couple of factors, which I’ll explain in section 4.

Underlying Security: This is the underlying stock that the option contract is being traded for.

Strike price: This is the pre-determined price that one can buy/sell the underlying stock for. Reminder: buying/selling the option contract does not mean you are buying/selling the underlying stock.

Number of shares: This is self-explanatory; the usual number of underlying shares is 100 for option contracts.

Expiry date: Options have an expiry date. After the expiry date, the option will be exercised (the buyer of the contract decides to execute the contract and buy/sell the underlying stock) or rendered worthless depending on whether the price of the underlying stock is above or below the strike price, depending on whether it is a call or put option respectively, which I will be explaining about in the next section.

2. Call and put options

Buying call options: A call option is a contract whereby the buyer has the right to buy an underlying stock within a specified time period (up to the expiry date) at a pre-agreed price (strike price). Instead of buying the stock, you decide to pay a premium to have the right to buy the stock later. Buying an option is also known as going “long. Here’s an example: Stock ABC is trading at $100 and has there is an option contract with a strike price of $100 costs a $2 premium. You will have to pay $2 _100 (number of shares for the contract) = $200. Say the next day, the stock price increases to $110 and you decide to exercise your right. You will pay $100 _100 shares = $10000 to buy the shares, and you can sell the shares in the market at the trading price of $110 and earn $110 * 100 = $11000. Your profit is $800, which is how much you gained from selling the stock at a profit minus the premium you paid for the contract ($11000 - $10000 = $1000, $1000 - $200 = $800). Thus, your maximum loss will be the premium paid (if you do not exercise your option) and the maximum profit is theoretically unlimited as you can sell the shares you obtained in the open market for a higher price. Here is the graph for buying a call option (you can ignore the expiration portion).

Source: Investopedia

Selling Call options: However, there must be somebody who is willing to sell the shares of ABC to you at a fixed price. This is where the seller of the option contract comes in. Selling the contract is also known as “shorting” and “writing” the option contract. When you are buying your call option, there is another party on the other end writing the contract to you and agreeing to sell their shares at the pre-determined price. The premium you are paying for your contract is given to the other party who is writing the contract, as they agreed to sell their shares at a fixed price. Think about it this way, the one who is writing the call option should receive the premium as they are forgoing potential upside in the stock by selling it to you at a fixed price. Let’s say you are instead writing the contract now. Your maximum profit is the premium gained from the buyer, and your maximum loss is unlimited as the shares you own can theoretically drop to 0. Here is the graph for writing/selling a call option (this scenario is for when you already own the underlying shares, it is also possible to not own the shares and write a call option, it’s called naked call, but that’s a topic for another day):

Source: Investopedia

Buying put options: A put option is a contract whereby the buyer has the right to sell an underlying stock within a specified time period (up to the expiry date) at a pre-agreed price (strike price). Put options are essentially the opposite of call options. Let’s walk through a scenario: Let’s say you bought 100 shares ABC at $100 and bought put options that costed $2 with a strike price of $100. The next day, the price of shares ABC fall to $80, and you decide to exercise your put options. Your loss is limited to the premium of the contract ($2 _100 = $200) compared to if you did not buy the put options, in which case your loss would be $20 (drop in stock price) _100 = $2000. On the other hand, if the stock price increased to $120 the next day, your profit would be the gain in stock price minus the premium paid ($2000 - $200 = $1800). Thus, your maximum loss is the premium paid and maximum upside is unlimited if the stock price goes up. Here is the graph for a buying a put option:

Source: Investopedia

Selling put options: Like call options, there must be another party on the selling side of the contract. In the case of a put option, the seller/writer of the contract must buy the shares at the strike price if the option is exercised by the buyer. Let’s go through the case of writing put options: Shares of company ABC are selling at $100 today, and you write a put option worth $2 with a strike price of $80. If the price of the shares drops to $70 and the buyer of the put option decides to exercise his contract. You will have to buy the shares at $80 but you would have made a premium of $2 per share. If the price of the stock remains at $100 and the option expires, you would have simply collected the premium. Thus, your maximum gain is the premium of the contract, and the maximum loss is unlimited as the price of the stocks you bought can continue to decrease after you buy them. Warren Buffet uses this strategy to buy stocks at a discount and collect the premium. Here is the graph for selling put options:

Source: TRADEPRO Academy

Here is a summary of buying and selling calls and puts:

Source: VectorVest Canada

3. Why options?

Call options: Flexibility to buy if you’re bullish

Imagine you do not own shares of a certain company yet, and you want to own it in the future, and you believe that the stock price will increase in the future. By buying the call option, you secure yourself shares at a fixed price in case the price of the stock increases in the future. In case the stock price drops in the future instead, you would have only lost the premium of the call option you paid for versus the capital you would have lost for the stock if you decided to buy it earlier.

Put options: Insurance for stocks you already own

As explained in the buying put options scenario, you could potentially be limiting your losses if you buy put options. Stock prices can fall drastically during bear markets, and if you would like to limit your losses, you can transfer this risk on to someone else, the person who sells you the option contract. Like insurance, you are paying the insurance company to take on the risk for your medical expenses, you are paying the put option seller to take on the risk of falling stock prices for you.

In fact, most option contracts are used as trading tools themselves and are rarely exercised. The price of options contracts itself tends to fluctuate (I will explain the reasons in the next section) which allows traders to earn from the price movement of the contracts. Thus, the reality of options trading is much more complex than what I have explained, but it is important to understand the basics of how the contracts work before going on to learn about various options trading strategies.

4. Factors affecting price of option contracts

Underlying stock price: If the price of the underlying stock increases, the price of the call option increases and vice versa. Imagine you had a long call option with a strike price at $100 and the stock price was $100 when you bought the call option, and now the price of the stock increased to $110. Naturally, there will be more demand for the call option you bought as more people will want to buy the stock at $100 (strike price) instead of $110. Now imagine you had a long put option with a strike price of $100, and also bought it when the stock price was a $100: When the stock price increases to $110, the demand for put options will reduce as more people will want to sell at $110 instead of $100 (strike price).

Volatility of underlying stock: A higher volatility will translate to higher option prices. With more volatile stocks, there is a higher potential for the stock to reach the strike price of the contract, which will allow you to exercise your contract.

Time frame: The longer the time frame, the more the option contract will be worth, as there is more flexibility to make your decision. For example, imagine I gave you a month versus a week to buy/sell a stock at a fixed price and asked you to pay a sum for signing this contract. Naturally, the month long one will be worth more. The depreciation of the options contract overtime is called time decay. Most stock options have either a weekly, monthly or quarterly expiration.

Source: Investopedia

5. Conclusion

This is barely scratching the surface of the options market. If you really do want to trade options, you must be committed to researching more about various options strategies. With any trading, you cannot let emotions get the better of you. The rule still applies: Do not invest/trade in what you do not understand. Furthermore, your losses can exceed your initial capital, so do be careful. I would also like to thank my friend Sheng Han for explaining some of the concepts to me! You can reach out to me in the comments if you need any clarification on the concepts above!

Disclamier 2.0: This should not be taken as advice to time the markets! My sole intention of writing this was so that people have a basic understadning of various financial instruments.

Cover Photo: IFM Trading Academy